In previous columns, I have discussed the changes to retirement account regulations stipulated by the SECURE Act of 2019 and some strategies to mitigate the effects of the new rules. One such strategy is using life insurance in a retirement account. IRA expert Ed Slott believes that for many IRA owners, especially those with large balances with existing trusts, this option has many advantages.
One of the major provisions of the SECURE Act is that the IRA stretch option was eliminated for most nonspouse beneficiaries and replaced with a 10-year rule. The 10-year rule is now in effect for IRA and Roth IRA beneficiaries who inherited accounts from owners who died in 2020. It stipulates that the beneficiary must withdraw all assets from the inherited IRA by the end of the 10th year after the original account owner’s death.
Some beneficiaries are still eligible to use the old stretch rules, namely spouses, minor children (not grandchildren), disabled or chronically ill individuals, and those not more than 10 years younger than the IRA owner. The “stretch” refers to the ability of the beneficiary to withdraw the assets over his or her lifetime, yielding more tax-deferred growth.
The IRA owners most affected by the rule change are those with the largest IRA balances, who, as a result, established sophisticated estate plans utilizing trusts as IRA beneficiaries to ensure that the funds are not misused by beneficiaries due to mismanagement, lawsuits, divorce, bankruptcy or financial scams.
Unfortunately, as a result of the SECURE Act, most of these trusts could not meet the desired objectives without large tax costs. The 10-year rule, specified in the new law, overrides provisions in the trust that allowed for longer withdrawal periods.
Using life insurance, however, will allow owners more post-death control and less tax. In addition, owners would have more long-term stability and guaranteed payout as long as reputable life insurance companies are selected. If the life insurance is purchased with IRA withdrawals, there will be taxes due, but tax rates have been lowered, and after age 72 there would be required RMDs with the associated income tax liability. When withdrawals from IRAs are used to purchase life insurance, the RMD will be reduced in subsequent years, resulting in lower future tax liability. If no action is taken by IRA owners, nonspouse beneficiaries will be forced to withdraw all of the IRA assets over a 10-year period with the associated income tax liability, when many of the beneficiaries may be in their peak earning years.
Slott has indicated that many existing trusts named as the beneficiary may have to be scrapped. They can be replaced in favor of new, more simplified trusts to inherit the life insurance. Life insurance trusts are more flexible and customizable for clients, and they don’t require all the IRA/RMD language that complicated the IRA plan. The life insurance proceeds paid to the trust after death will be income-tax free and can follow the intent of the owner without the tax rules that complicate the IRA trust.
Life insurance trusts can be more versatile for multigenerational planning, keeping the funds protected for decades, if desired. Because of the SECURE Act, many existing trusts named as the beneficiary would require the funds to be released to the heirs by the end of the 10th year.
Naturally, the life insurance option can work only for owners who qualify for life insurance. If you do not qualify, either because of age or health, you can consider a Roth conversion. The beneficiaries would still be required to make a withdrawal within 10 years, but the withdrawals would be tax-free for the beneficiary.
(Article written by Elliot Raphaelson)